With around Rs. 500 billion in Treasury bonds expected to mature during the first nine months of this year, market analysts say it would be tough for the Central Bank to maintain price stability and lower interest rates unless the government introduces significant fiscal reforms and foreign direct inflows increase this year.

The Public Debt Department of the Central Bank will conduct another record high Treasury bond auction this week, amounting to Rs. 45 billion. Earlier this month, the bank upsized a Rs. 40 billion bond auction to Rs. 43.2 billion on overwhelming demand from foreign investors.

"These are record high bond auctions on account of near Rs. 500 billion worth of bonds maturing during the first nine months of this year. We doubt local investors could absorb this capacity which means foreign investors would have to carry the weight," a market analyst said.

Unless this happens, the Central Bank would have to print money and this would put pressure on inflation. Increased domestic borrowings by the government would also put pressure on interest rates and if rates are manipulated, the exchange rate would be affected, "leading to another cycle of balance of payments problems," the analyst said.

"It is tough to be optimistic about macroeconomic stability going forward considering the fact that the government is not going to international capital markets this year. Significant fiscal reforms would have to be made, starting with the CEB and CPC, where consumer prices would have to be determined by a realistic formulae, which should come through by the end of this month or the next."

Another dealer said persistent government borrowings from the domestic market must not be accompanied by manipulations to the interest rate. Keeping interest rates low will only create credit, and then the exchange rate could come under pressure as well.

Secondary market bond yields had been on the rise over the past few weeks despite a monetary policy rate cut in December.

"This is because deposit rates are still high with competition among banks stiff. So naturally lending rates are also high. Treasury bill and bond auctions are being subscribed at higher rates on account of this, but of course with captive sources such as the EPF, NSB and other state banks in play, yields are kept under control," one analyst said.

Last Thursday, secondary market yields fell sharply to around 11.05/10 percent on the five year bond from an opening position of 11.40/45 with investors eyeing another strong foreign showing at the Rs. 45 billion bond auction this week.

The rupee closed flat against the US dollar on Thursday (24) with importer demand still persistent. The rupee closed at Rs. 127.00/10 against the greenback.

Economists and the Central Bank have warned that the government would have to stick to its fiscal targets in order to maintain benign macroeconomic fundamentals this year.

"The domestic sector of the economy is expected to continue to deteriorate as the government will attempt to buy the support of the masses through new recruitment and pay rises to the public sector (middle-class) and extravagant subsidies and hand-outs to the rural population in order to contain the widespread discontentment caused by the arbitrary and illegal impeachment of the Chief Justice, which would result in soaring fiscal deficit," a senior economist, Dr. Muttukrishna Sarvananthan, Principal Researcher of the Point Pedro Institute of Development, said recently adding that economic growth was unlikely to exceed 6 percent in 2012, with prospects not that bright for 2013 either.

"Moreover, the crisis of governance caused by the arbitrary and illegal impeachment of the Chief Justice will seriously undermine business confidence within the country and severely restrict the flow of Foreign Direct Investments (FDIs) to the country. No sane foreign investor would invest in a country where the Executive and the Legislature blatantly violates the Constitution of the country which they have taken oath to uphold. This is on top of the enacting of the "Act to provide for the vesting in the government identified under-performing enterprises and under-utilised assets" of 2011 (popularly known as the Expropriation Act)," Dr. Sarvananthan said.

With the budget deficit estimated at Rs. 507.4 billion this year, the government hopes to raise Rs. 86 billion from foreign sources to finance the deficit, a sharp decline from Rs. 205.6 billion estimated for 2012, while domestic borrowings are estimated at Rs. 421.4 billion, almost doubling from 259.6 billion in 2012.

Non bank domestic borrowings are expected to carry the weight of the deficit, surging to Rs. 289.4 billion this year from 84.6 billion in 2012.

"Non bank borrowings will be high (in 2013). This means more funds would be mobilised by selling Treasury bills and bonds to the public and borrowing from EPF, NSB and Sri Lanka Insurance," Institute of Policy Studies Executive Director Dr. Saman Kelegama said, addressing a post budget seminar organised by the Sri Lanka Economic Association and Alumni Association of the University of Peradeniya (Colombo Branch) last November.

"For such borrowings to be effective interest rates would have to be attractive and this, among other factors, implies there is limited space for a reduction in policy interest rates," he said.

But in December, the Central Bank surprised many by lowering policy interest rates. The Central Bank said it wanted to spur growth, but market analysts said the lower rates would actually help the government.

Earlier this month, Central Bank Governor Ajith Nivard Cabraal said the government had been successful in staying within the 2012 budget targets despite a series of adjustments made since February 2012 to curb a balance of payments problem.

"It was a tough call, but a serious commitment has been made by the government towards fiscal consolidation. The budget deficit for 2012 is estimated at 6.2 percent and I am confident the government would meet this target. It may over shoot this target, but it would only then be something like 6.3 percent or so," Cabraal said, unveiling the ‘Road Map for Monetary and Financial Sector Policies for 2013 and Beyond’

"Inflation has stayed within single digits for the past 47 months and the Central Bank will continue to focus on keeping demand driven inflationary pressures in check. In our fight against inflation, we would be watching the government’s fiscal performance closely," he said.

According to the latest available data, the budget deficit as a percentage of GDP for the first nine months of 2012 reached 6.44 percent, exceeding the full year’s target of 6.2 percent, as government expenditure grew nearly twice as fast as revenue growth.